Navigating an Overvalued Market, Part 2

In yesterday's column, I outlined why I believed the market is overdue for a 5% to 8% pull back. I don't see a major correction as Federal Reserve policies are still extraordinary supportive.

However, the shocks to consumer spending (payroll tax holiday expiration and high gas prices) and earnings estimates that have come down for 2013 even as the market has rallied over the last year are two large concerns. I believe the market has not factored either in fully yet.

Yesterday, I went through how I bought cheap insurance on my long portfolio by buying slightly out of the money puts on the S&P (SPY) and moved a decent portion of my portfolio over the last several weeks to cash.

Today I will go over how I am using out-of-the-money bull call spreads to keep my portfolio from underperforming too much due the cash in my portfolio. This will keep me in a better position if I am wrong about an impending decline in the market.

In Monday's column, I will cover several stocks on my "shopping list" if we do get the predicted pull back in equities.

I am big believer in using bull call spreads when I am pessimistic about the current market direction. It's also a very beneficial strategy to use when volatility and option premiums are low like they are now. I utilize short term bull call spreads on stocks that have recently been beaten down unfairly, for special situations or when I think the stock will significantly beat during an upcoming earnings report.

I try to structure my call spreads to return 300% or better if I turn out to be right. This way it can be a profitable strategy if I am only right a third of the time. These plays have been very kind to me so far in 2013 as about half of my calls have turned out to be correct so far.

I have scored 200% to 500% returns so far this year on Best Buy (BBY), Herbalife (HLF), Avon Products (AVP), Transocean (RIG) and Nasdaq OMX Group (NDAQ) while whiffing completely on Barrick Gold (ABX), NetApp (NTAP) and a few others. I try to post these moves on the Columnist Conversation section of these pages and tweet them as well when my positions are executed.

I use long term bull call option spreads for stocks that have not participated in the market rally and where sentiment on the equity is currently negative. I want them to be cheap and I want to be able to envision some catalysts that could unlock value over the next year. Here are two plays I made this week during the downturn.

Kohl's (KSS): Other than J.C. Penny (JCP) and Sears Holdings (SHLD), this probably is the most unloved department store retailer in the markets. However, the shares are cheap at around 10x forward earnings and they pay a dividend near 3%. The company has had some scattered rumors of being a takeover candidate. I don't believe that is likely, but it is a possibility if M&A activity continues to be robust.

More importantly the stock was selling 15% higher just a few months ago and Kohl's is selling at the bottom of their five year valuation range based on P/E, P/S, P/CF, P/B. The shares could benefit from doing a better job with their merchandising in 2013, attract interest from an activist hedge fund manager(s), or consumer spending turns out stronger than I expect or by continuing to raise their dividend.

Strategy: With the stock trading around $46.50, I bought some Jan. 14 $55/$57.50 bull call spreads for 60 cents. If I am right, I make a better than 300% return and it is a lower risk play than owning the stock in this challenged retailer directly.

Cypress Semiconductor (CY): This chip maker has seen better days and was 80% higher a year ago. The stock yields 4.5% and sells at 5x operating cash flow. Revenue is expected to post a 10% gain in FY2014 after being flat for this fiscal year so it might be a second half of the year story. In addition, Needham just upgraded the shares to a buy, the company's CFO recently made an insider purchase and the stock has built a base at these levels over the last four or five months.

Strategy: The stock is trading at $10, I bought some Jan. 14 $13/$15 bull call spreads this week for 25 cents. If the stock recovers just over half its decline it had in 2012 over the next year I can book a 700% gain for a very small outlay.